Why Are Crypto Prices High? New Research Says Shorting Capability Is Key

The rally in cryptocurrency prices in the last three years has been as incredible as it has been mysterious. Without an established framework for valuation, forecasts for cryptocurrency prices have become anyone’s game. Rookies and experts have pontificated about and forecast future cryptocurrency prices. But none has proven correct.

A recently-released paper by a researcher at a business school in Australia has an explanation for why this is so. Wang Chun Wei from UQ Business School at the University of Queensland in Australia analyzed price data for mainstream and “joke and scam” cryptocurrencies, such as Dogecoin, and concluded that their prices are inflated only because a resale market, with further speculative prices, existed for them and not because they possess intrinsic value.

Wei found that low turnover portfolios (or portfolios in which there was not much frequent trading) outperformed high turnover portfolios by 7.8% per month over the last 3.5 years (Jan 2015 to Jun 2018). In a conversation with Coindesk, he said that prices for mainstream cryptocurrencies, such as bitcoin and ethereum, had speculative behavior and that it was unlikely that traded price for these cryptocurrencies reflect only fundamental value.

How Resale Option Hypothesis May Explain Cryptocurrency Prices

The researchers’ hypothesis investigates the role of resale option hypothesis – a theory in finance in which an asset’s value is measured the possibility or option of selling it to someone at a higher price down the line. Fundamental valuation factors, such as market size, executive team, and product utility, are not considered.

Two conditions must be met in order for resale options to be high in a market. First, there must be heterogeneity in opinion or multiple conflicting assessments regarding the asset’s value. Second, investors must find it difficult to short the asset, thereby providing a leeway for free run of its price and making it difficult to apply a downward pressure. In effect, the market in such cases encourages long positions because they make it possible to resell the asset at even higher prices to future buyers. Elements of this thesis can be found in the venture capital market, where shares of privately-held companies reach sky-high valuations based on an optimistic take of future target markets.

Bitcoin and, indeed, cryptocurrency markets possess both these characteristics. The cryptocurrency’s proponents consider it revolutionary and frequently compare it to gold as a store of value. But its detractors claim it is worthless and that its price will crash to zero in the future. Similar assessments have been made about other cryptocurrencies. While there have been efforts made to value cryptocurrencies, the jury is still out on whether they are effective. For the most part, cryptocurrency price estimates are guesses, sometimes based on fundamental analysis (such as regulatory clarity or estimated target market) or short-term technical indicators commonly used in equity markets.

It is also difficult to short bitcoin and other cryptocurrencies. The risk associated with bitcoin trading is best exemplified by CME and Cboe bitcoin futures trading markets, which only track price movements at underlying cryptocurrency exchanges and are cash-settled. Bitcoin’s price rallied when they first introduced last December on hopes that they would bring liquidity and institutional investors to the market. As with other commodity futures, they were expected to influence prices for bitcoin. Almost a year later, however, the trading volumes for bitcoin futures remains thin and they play a negligible role in determining the bitcoin price.

Will Resale Options Continue To Influence Cryptocurrency Prices?

Resale options are mainly a function of lack of information and transparency in markets. For the most part, cryptocurrency markets are inscrutable to lay investors. A profusion of complex terminology and frequent high-profile scams has further dimmed the allure of their high returns. But that might change in the near future as institutional investors enter the space and cryptocurrency investment becomes mainstream. For example, NYSE owner Intercontinental Trading Exchange (ICE) is set to begin offering bitcoin futures trading next month. “Theoretically, the introduction of shorting instruments should reduce the resale option value, and consequently reduce bitcoin price (the latter which we can see clearly),” Wei told Coindesk.